Smiths well poised for renewed opportunities

In early September, Smiths Group (SMIN) achieved something of a milestone when it offloaded its medical unit to ICU Medical Inc. in a cash/scrip deal worth $2.7bn (£1.97bn) on an enterprise basis, plus earn-out provisions. The attempt to hive-off Smiths Medical was a drawn-out process, with cancellations and delays a source of frustration for management and shareholders alike. However, the group is now free to focus attention on its core industrial technology business, while shareholders will benefit from a related buyback.

It is difficult to dissect the group’s full-year figures due to the disruption to some of its end-markets, yet there has been a marked improvement in operating margins across its business segments through the second half of FY2021, leading to an overall 140-basis point increase year-on-year.

The impact of the pandemic on certain sales channels is perhaps best illustrated through Smiths Detection, a provider of security equipment and systems for several sectors, most notably the aviation market. At the onset of the pandemic, Smiths Detection was set to benefit from record orders from its original equipment manufacturers (OEMs) segment.

Indeed, these orders partly mitigated the subsequent fall-away in tender activity in both civil aviation and other security systems, both of which rely heavily on aftermarket sales. The challenging market conditions are best seen in the latter business segment, where underlying sales were down by 21 per cent. But that’s set - somewhat counter-intuitively - against a solid showing from the aviation business, where weakness in civil volumes is being offset by aerospace/defence channels.

The civil aviation market could take a couple of years to recover, but management has taken a proactive stance, instituting measures to deliver operating margins of 18-20 per cent. These restructuring measures have cost £65m over the past two financial years, but are expected to deliver annual savings of £70m going forward.

The localised nature of Smiths’ supply chain arrangements means that it is not being unduly affected by the unholy trinity of semiconductor, energy and logistics issues. And the improved efficiencies are also reflected in a 125 per cent cash conversion rate, which fed through to decreased borrowings and a 40 per cent hike in free cashflow to £383m. Performance remains chequered across the group’s business segments, but continued working capital discipline helped to boost ROCE by 140-basis points to 13.2 per cent. Market challenges notwithstanding, a forward rating of 14 times Investec’s adjusted earnings forecast is not overly demanding, particularly given a prospective dividend yield of nearly 3 per cent. Buy.

Last IC view: Hold, 1,556p, 26 Mar 2021